Secret lessons from DIY funds

SUMMARY: Taking SMSFs seriously – now fund managers and stock brokers want to know how we think so they can second guess us.

Yes, self-managed super funds are a force to be reckoned with. You and I have known that for some time.

But it’s only now just dawning on some elements in the finance sector. They’ve realised that the SMSF sector is at a tipping point where it is a significant driver of market direction.

“SMSFs are a stampeding herd, with lots of money, and we need to adjust how we invest.” This is the clear message to come from a recent piece of research from international broking firm Credit Suisse to an international client base.

Part of this research, titled Rise of the Selfies, admits they have underestimated the power being packed by SMSFs. They should have understood that growing influence on equity markets earlier and made adjustments to their share recommendations to clients.

The research is a fascinating insight from those on the outside looking in, trying to guess what it is we’re doing and why and seeing if they can’t adopt a “if you can’t beat ’em, join ’em” philosophy to our own investing patterns.

What’s made them come to the startling discovery that SMSF investors need to be watched? For one, they’ve realised that SMSFs have about $220 billion invested in Australian shares, which makes up about 16% of the capitalisation of the Australian share market (up from 12% in mid 2009).

Further, SMSFs are tipping in about $2 billion of new money into equities each quarter ($8 billion a year), which will continue for a number of years. Overall, they note, there are about 510,000 SMSFs, operating on behalf of nearly one million members.

And SMSFs have investing biases. Credit Suisse claims that understanding those biases is key to understand how to co-exist with the mountain of money that SMSFs control and where it is likely to flow.

Interestingly, the research seems to adopt a viewpoint that SMSFs have sprung from nowhere. And it only happened yesterday. There seems to be a genuine surprise that SMSFs have suddenly become a dominant driver of equity capital today.

Despite their being more than half a million SMSFs and probably nearly as many different investment strategies, Credit Suisse tried to tie down our equity choices into a few easy-to-follow rules. And, I’ve got to say, they did a pretty good job.

 

When it comes to selecting stocks, they’ve put SMSFs decision-making process into four categories.

Tier 1: These stocks will be owned by most SMSFs. And the criteria, roughly, are high dividend yields, with a history of dividend growth, franking credits, are large caps and are companies they comfortably understand. Into here goes the major banks and Telstra.

Tier 2: Yields aren’t quite as big, but are still large companies, such as Woolworths, Coca-Cola Amatil, Wesfarmers and A-REITs. They might have been put into tier 2 because they cut their dividends and therefore got dumped by many SMSFs.

Tier 3: Top-50 companies that don’t fit into the first two.

Tier 4: Speculative stocks “like bombed out large caps and small cap miners”.

All up, that’s a pretty fair breakdown of how stocks are selected by SMSFs, given my experience with many of you over the last six years, if you accept that the findings have to be reasonably broad generalisations. Banks and Telstra are favourites and almost certainly will be forever. Unless they break the rule – high, rising, franked dividend yields.

What was particularly interesting was what Credit Suisse’s analysts decided to quickly implement, as a result of “discovering” this.

They are no longer going to recommend the shorting of  banks or Telstra. There’s no point fighting the weight of money that will presumably always follow those “tier one” stocks.

“There is clear demand for these companies as long as they can continue to grow their dividends. We have previously been short Westpac in our stock allocation.

“But given the bank is a Tier 1 stock, we have come to our senses and step (sic) out of the way of these considerable flows.

“We will revist a potential short in the big banks or Telstra when they could be about to break their implicit contract with SMSFs and cut their dividend. We don’t think this will be the case in the near term.”

The second lesson Credit Suisse says they have learned is to put more weight on dividend yields and dividend growth and less on price-to-earning ratios and earnings-per-share growth. SMSFs don’t care as much about that as “professional investors” and the weight.

“Perhaps the rise of the Selfie is a reason why high-yielding stocks have done unusually well at this stage of the market cycle. Selfies were not as important during similar stages in the past.”

The third lesson is to buy what SMSFs are likely to turn to next. That is, find the stocks that will soon, or eventually, fit the “high, rising and franked dividend yield”. Credit Suisse suggests Rio Tinto could go in this bag – if not into tier 1, then tier 2.

The last lesson is actually a major criticism of SMSFs. “Selfies are retarding growth in Australia. Perversely, they control much of the equity that could be used for new investment, but are demanding dividend increases instead.”

Credit Suisse said SMSFs aren’t interested in financing growth and this should be a frustration to politicians.

“If companies are not investing, then policy makers will have to do more of the heavy lifting … companies will be too busy keeping their powerful investor base happy.”

Credit Suisse also notes the “bar bell” position that SMSFs have in relation to their investments – that is their two biggest investments are cash and equities, which are at opposite ends of the risk scale.

Corporate bonds should be a “natural asset for an ageing pension scheme” for SMSFs, as they provide higher income returns than cash.

“Of course, there is no real credit market in Australia for this massive group of investors to buy into. But it seems like Selfies are trying to re-create the return and volatility profile of corporate debt through their bar-bell position in equities and cash.”

Risks to SMSFs

From their discussions with their panel of advisers, the researchers also outlined the major risks for SMSFs. And these risks are probably the most helpful advice.

The dearth of quality bonds in Australia means SMSFs feel forced into equities to get yield, particularly when interest rates are low. As a result, they are inappropriately invested as they lack the diversification that bonds would provide, if they could be convinced to invest in them.

The advisers interviewed by Credit Suisse said that trustees are just as prone as any other non-professional to suffer from panic attacks that leads to selling and buying at the wrong times.

Credit Suisse said that SMSFs also seem to have investment return assumptions that are simply too high. They have benefited from massive returns in shares and property in the last few decades and are reaching for those returns to continue.

And, finally, the influx of “unprofessional advisers” was noted by the interviewed advisers. Like bees to a honeypot, some new advisers are arriving on the scene with no other purpose than to strip SMSFs of fees. They outlined that geared property spruikers were the biggest danger here.

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So, essentially, they’re on to us. Or a good portion of us.

How will that pan out? Well, if enough of them wake up to how we invest, they may add to what they claim is the distortion of the market being created by SMSFs.

If SMSFs love banks and there will always be fresh money coming in to the banks, then more institutional investors, or stock brokers, might start pushing more money into those stocks. It certainly couldn’t do any harm to the share prices of banks if these clowns stopped shorting them.

But SMSFs will, eventually, probably need to realise that their humble investment strategies could become more mainstream. And that could lead to bubbles.

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The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au